CLE Materials for Panel #1 - George Washington University Law ...

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WILMARTH 4/1/2011 1:11 PM 972 OREGON LAW REVIEW [Vol. 89, 951 nonbank lenders and CRAs who worked with LCFIs) collected lucrative fees at each stage of originating, securitizing, rating and marketing the risky residential mortgages, commercial mortgages, credit card loans, and LBO loans. 71 Based on the widespread belief that LCFIs were following an “originate to distribute” strategy, both managers and regulators of LCFIs operated under the illusion that the credit risks inherent in the securitized loans were being transferred to the ultimate purchasers of structured-finance securities. 72 In significant ways, however, LCFIs actually pursued an “originate to not really distribute” program, in which they retained significant risk exposures from their securitization programs. 73 For example, LCFIs decided to keep large amounts of highly rated, structured-finance securities on their balance sheets because regulators allowed LCFIs to do so with a minimum of capital. In the U.S., LCFIs took advantage of a regulation issued by the federal banking agencies in November 2001, which greatly reduced the riskbased capital charge for structured-finance securities rated “AAA” or “AA” by CRAs. The 2001 regulation assigned a risk weighting of only 20% to such securities in determining the amount of risk-based capital that banks were required to hold. 74 As a practical matter, the 2001 rule cut the risk-based capital requirement for highly rated tranches of RMBS and related CDOs from 4% to only 1.6%. 75 In Europe, LCFIs similarly retained AAA-rated structured-finance securities on their balance sheets because the Basel I and Basel II capital accords assigned very low risk weights to such securities. In contrast to the United States, European nations did not require banks to maintain a minimum leverage capital ratio and instead required banks only to meet the Basel risk-weighted capital standards. As a result, European banks did not incur significant capital charges for 71 Crotty, supra note 33, at 565–66; Wilmarth, supra note 4, at 984–87, 995–96, 1017– 20, 1034–42; see also id. at 995 (noting that “[f]ee income at the largest U.S. banks (including BofA, Chase and Citigroup) rose from 40% of total earnings in 1995 to 76% of total earnings in 2007”). 72 Wilmarth, supra note 4, at 995–96, 1025–26, 1041–42. 73 Id. at 970–71, 1032–35, 1039–43, 1046–48; see also Acharya & Richardson, supra note 34, at 198–201; FIN.SERVS.AUTH., supra note 56, at 15–21. 74 See Risk-Based Capital Guidelines, 66 Fed. Reg. 59,614, 59,625–27 (Nov. 29, 2001); ARNOLD KLING, NOT WHAT THEY HAD IN MIND: A HISTORY OF POLICIES THAT PRODUCED THE FINANCIAL CRISIS OF 2008, at 25–26 (2009), available at http://ssrn.com /abstract=1474430. 75 KLING, supra note 74, at 25 fig.4.
WILMARTH 4/1/2011 1:11 PM 2011] The Dodd-Frank Act 973 holding on-balance-sheet, AAA-rated instruments, due to their low risk weights under Basel rules. 76 LCFIs also had revenue-based incentives to keep highly rated structured finance securities on their balance sheets. As the credit boom reached its peak, LCFIs found it difficult to locate investors to purchase all of the AAA-rated tranches they were producing. Managers at aggressive LCFIs decided to assume “warehouse risk” by keeping AAA-rated tranches on their balance sheets because they wanted to complete more securitization deals, earn more fees, produce higher short-term profits, and distribute larger compensation packages to executives and key employees. 77 By 2007, Citigroup, Merrill, and UBS together held more than $175 billion of AAA-rated CDOs on their books. 78 The huge losses suffered by those institutions on retained CDO exposures were a significant reason why all three institutions needed extensive governmental assistance to avoid failure. 79 In addition, LCFIs retained risk exposures for many of the assets they ostensibly transferred to OBS entities through securitization. Regulators in the United States and Europe allowed LCFIs to sponsor structured investment vehicles (SIVs) and other OBS conduits, which were frequently used as dumping grounds for RMBS and CDOs that 76 Acharya & Schnabl, supra note 70, at 94–98; ANDREW G. HALDANE, EXEC. DIR., FIN. STABILITY, BANK OF ENG., BANKING ON THE STATE 5–8 (2009), available at http://www.bis.org/review/r091111e.pdf. Because European banks did not have to comply with a minimum leverage capital ratio, the thirteen largest European banks operated in 2008 with an average leverage capital ratio of 2.68%, compared to an average leverage capital ratio of 5.88% for the ten largest U.S. banks (which were required by regulators to maintain a leverage capital ratio of at least 4%). Similarly, the four largest U.S. securities firms had an average leverage capital ratio of only 3.33% because the SEC did not require those firms to comply with a minimum leverage ratio. Adrian Blundell-Wignall & Paul Atkinson, The Sub-prime Crisis: Causal Distortions and Regulatory Reform, in LESSONS FROM THE FINANCIAL TURMOIL OF 2007 AND 2008, at 55, 93–94, 95 tbl.6 (Paul Bloxham & Christopher Kent eds., 2008), available at http://www.rba.gov.au/publications/confs /2008/conf-vol-2008.pdf; see also McCoy et al., supra note 14, at 1358–60 (explaining that the SEC allowed the five largest U.S. securities firms to determine their capital requirements based on internal risk models, with the result that leverage at the five firms increased to about 30:1 by 2008). 77 Wilmarth, supra note 4, at 1032–33; see also Gian Luca Clementi et al., Rethinking Compensation in Financial Firms, in RESTORING FINANCIAL STABILITY, supra note 34, at 197, 198–200; Crotty, supra note 33, at 568–69; Jaffee et al., supra note 45, at 71–73. 78 Clementi et al., supra note 77, at 198–200. 79 GILLIAN TETT, FOOL’S GOLD: HOW THE BOLD DREAM OF A SMALL TRIBE AT J.P. MORGAN WAS CORRUPTED BY WALL STREET GREED AND UNLEASHED A CATASTROPHE 133–39 (2009); Blundell-Wignall et al., supra note 11, at 4, 7–11; Jaffee et al., supra note 45, at 68–69, 72–73.
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